By Matt Hussey
5 min read
In our first chapter of how to invest, we gave you a 10,000 foot view on what moves and motivates the crypto industry. Today we’re going to be taking a look at one of crypto’s most productive products from a profit point of view: staking and lending.
Below we explore what they are, how they work, what are some of the potential pitfalls, and why they’re so popular.
Staking is a financial term that’s fairly unique to the cryptocurrency markets. In a nutshell, as an investor you agree to stump up the crypto you invest in a specific network to help the network validate transactions. In exchange for doing that, you earn rewards, typically in the form of tokens.
The key to staking is a consensus mechanism known as proof of stake. Bitcoin and many other blockchains rely on a consensus mechanism called proof of work. In this system, miners expend huge amounts of computing power to solve a puzzle that helps the blockchain validate all the transactions inside a block. The first to solve the puzzle earns the reward.
At the time of writing, there is nearly $30 billion locked in staking, with the biggest staking networks including DOT, Ethereum, EOS, Algo and ADA.
While this is a robust and secure way of keeping a blockchain running, all the computational power expended by all the miners that didn’t solve the puzzle is ultimately wasted. This is why some commentators say proof of work is “inefficient” and why you might see headlines saying Bitcoin uses as much energy as Chile.
In a proof of stake blockchain however, the mining process is different. Instead of machines competing to solve a puzzle, the network assigns a miner, or node, the right to perform the validation work depending on the amount or stake of tokens that node currently has.
Once the node is given the nod by the network, it can get to work validating transactions. Once it solves the problem, it's rewarded with tokens, and the stake is returned back to the investors.
Like with mining pools, groups of stakers often get together to form staking pools to make the chances of being selected higher. We’ll explore these more below.
Staking pools are where several investors collect their tokens together into a pool, and then typically a pool operator will do the allocation on the investors' behalf. This allows investors without a working knowledge of a blockchain network’s machinations to get involved in the network. It also increases the chances of you earning rewards for your stake.
However, there will likely be fees involved and the reward will potentially be lower as it’s divided among more investors. For investors looking for a more consistent payout, and aren’t as interested in being part of the network, lending might be a better option, which we explore more below.
While staking helps secure a network, lending allows investors to passively earn interest to help facilitate trading.
Several DeFi, or decentralized finance companies offer the ability to lend your crypto to other traders and earn interest as a result. At the time of writing, there is more than $8 billion invested in lending companies like Maker, AAVE and Compound.
These companies create lending pools, that your crypto goes into. The pools then create an interest rate-these vary depending on what cryptocurrency you are lending and the rate set by the company itself-and you begin earning interest almost immediately.
Lending pools are what contributed to 2020’s DeFi boom as new lending networks sprung up offering huge returns for investors willing to put their crypto in their hands. But there are some pitfalls when it comes to staking and lending, as we explore below.
Staking and lending do have their downsides. With staking, the network’s volatility, and longevity could have a serious impact on your investment.
As rewards are paid out in the token of the network, a sudden drop in the network’s value means your asset’s value drops with it. If you decided to stake your coins in a network that gets hacked, the value of your investment could also go down.
If the network suddenly becomes less popular that too could have an impact.
With lending, the company you lend to sets the interest rate, and these can vary over time, depending on how popular that particular asset is.
And both staking and lending facilities can ask you to move your crypto out of your own wallet into a company’s wallet, which might seem at odds with crypto’s ethos of “not your keys, not your crypto.”
If buying a cryptocurrency and holding it is the first step on the ladder of investing in cryptocurrencies, lending and staking is step two.
It requires only a few extra steps, and can help increase the size of your holding without having to do very much apart from choosing which platform to give your crypto to.
Feeling comfortable? Head on over to AAX where you can start earning a passive income using the Savings feature.
Disclaimer: The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment, or other advice.
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